Deal or no deal

Commentary: Buy-and-hold investors have to know when to sell and fold

BOSTON (MarketWatch) -- Individual investors typically sell mutual funds for one of three reasons: The market has changed, the fund has changed or they -- the individual investor -- have changed.

With that in mind, you would think that investors would have dumped their stock mutual funds over a year ago, when it was obvious that the stock market had taken a turn for the worse. If the miserable market wasn't enough to scare investors out of funds, then the changes to fund performance -- where years of solid track records have evaporated and one-time leaders are now fallen angels -- would have convinced investors it was time to go.

Yet there's still about $4 trillion in equity funds, and so you can only assume that money is determined to ride out the turmoil or is being positioned to profit when the recession ends. Or perhaps it's just there due to inertia and investor paralysis.

In December 2007, according to the Investment Company Institute, there was more than $6.5 trillion in equity funds; with the average equity fund having lost about one-third of its value in 2008, it would appear that $500 billion was pulled from equity funds and the rest of the shrinkage was caused by loss.

No regrets

It's too late for buy-and-holders to avoid the carnage, but not too late to salvage something from the wreckage.

The question for most investors holding their stock funds is how to set the point where enough is enough. Traditional mutual funds do not take stop-loss orders, where a sell is triggered when the share price falls to an investor's pre-determined jump-out point. (Investors can place stop-loss orders on exchange-traded funds, which trade like stocks.)

Still, most buy-and-hold investors never set an actual point where they will protect their winnings or cut their losses.

Further, most investors rely on research that always touts winners. Where stock researchers might say there is nothing worth buying or holding during a terrible market, the most popular and relied-upon mutual-fund research doesn't work that way, because it's more a description than a recommendation. Thus, 10% of all funds in an asset class will get Morningstar Inc.'s top five-star rating, regardless of market conditions. Another 22.5% get a four-star rating. And 20% of every peer group earns Lipper's top marks for total return, consistent return and preservation of capital.

"Many mutual fund investors, assuming that nothing has changed because the manager is still in place and the fund still has a good record in up markets or still gets a good rating from Morningstar, also assume the right path is to keep going, but they have to throw personal factors in there too," said Richard Geist, head of the Institute on the Psychology of Investing in Cambridge, Mass.

"It's really hard to determine in advance the point where you go from saying 'I can ride this out' to 'I can't take it any more' and planning what you'll do if you reach that point," he added.

Plan ahead

The key may be looking less at "asset allocation" and more at "purpose allocation," where money is invested with an eye toward the purpose it ultimately is supposed to serve.

Lou Harvey, president of Dalbar Financial Services in Boston, explains it as looking at different compartments of your life, where you need a certain amount of capital protected "so you can avoid eating dog food ... but you have other money that you can take more risk with because it's there to pay for travel in retirement or for luxuries or to leave an inheritance."

Dalbar is known for its study of investor behavior, which has shown that investors tend to perform much worse than the funds they own, buying only after run-ups and selling when things look bleak. Harvey acknowledges that investors who have stood by their funds could bail out now and be living proof of the statistics. "But if you see your portfolio shrinking," he said, "there comes a point somewhere between comfortable retirement and needing to eat dog food where your circumstances tell you to stop the bleeding."

"It may not be that you have changed," Harvey added, "but your circumstances have, and you need to protect what's left rather than continuing to leave it at risk. Even a dedicated buy-and-holder has to consider selling at that point."

Russel Kinnel, director of mutual fund research at Morningstar, said that any sell decision does not have to be an all-or-nothing, in-or-out of equity funds, but rather can involve re-evaluating financial circumstances and adjusting financial plans.

"The market makes you feel very much like you are not in control," Kinnel said, "but developing a better, clearer plan will make you feel better. Staying in the market longer than you can afford to is a bad idea, but so is sitting back planning to give up if your portfolio shrinks to a certain threshold. You need to balance protecting with what you have left with rebalancing to a portfolio you can live with and that still gives you a chance to reach your goals."

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